So, where does this myth of poor performance come from? Part of the reason is that in some cases, adopting sustainability does require investment – it costs money to implement it. Energy companies retooling to focus more on renewables do indeed need to spend millions on new infrastructure. Sourcing products from suppliers that pay their employees properly means costs go up. Less tangibly, a company with poor diversity may need to pay third parties such as recruitment consultants, also raising costs and cutting short-term returns.
This should, in theory, mean that companies that take sustainability seriously underperform. In fact, the reverse is usually true: the use of environmental, social and governance (ESG) principles by companies and investors can be shown to enhance performance. This is primarily due to the ability to reduce risks, particularly as standards are raised in all three domains to combat climate change or bad corporate behavior.
Financially materiality is key
At the core of improving decision-making by including ESG information in the process is taking an investment perspective and only analyzing issues that are financially material – they go to the core of a business. In other words, the focus should be on researching those ESG issues that have a direct financial outcome on company results in the longer term, and therefore feed through into investment returns. For a utility, these would be issues related to energy efficiency of its operations and its strategy towards the energy transition. For a bank, this would be governance, risk management culture and product stewardship.
Further, adopting ESG can lead to opportunities, or reduce risks. For example, the trend towards the adoption of electric cars has generated investment opportunities in both the car makers and their suppliers, including the new smart materials being produced such as lithium for batteries. Meanwhile, the role of ESG in reducing risks can be seen in how it has exposed potential supply chain problems in industries that had been reliant on cheap labor such as fashion and retailing. This in particular allows investors to pick the ‘wheat from the chaff’ when deciding which stocks or bonds to buy, in a ‘best-in-class’ approach.
Four studies prove outperformance
Four studies looking at this ‘added value’ issue in the past three years are particularly noteworthy. The extent to which this can add and not subtract value was first demonstrated in abstract in a 2015 study, ‘From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance’ by Oxford University and Arabesque Partners. This examined more than 200 sources including academic research, industry reports, newspaper articles and books, and concluded that “80% of the reviewed studies demonstrate that prudent sustainability practices have a positive influence on investment performance." 1
A separate survey later that year by Deutsche Bank’s asset and wealth management division in conjunction with the University of Hamburg went much further. The research examined the entire universe of 2,250 academic studies published on this subject since 1970, using data spanning over four decades until 2014. It concluded that ESG made a positive contribution to corporate financial performance in 62.6% of meta-studies and had negative results in only 10% of cases (the remainder were neutral).2
Higher stock returns
Better corporate results should in theory feed through into higher share prices. A 2016 study by Harvard Business School directly linked better performance and disclosure on material ESG issues to higher share prices for the first time. The paper entitled ‘Corporate Sustainability: First Evidence on Materiality’ made a clear case for the financial benefits feeding through into asset values.3
And sustainable investing is also about active ownership, partly achieved by engaging with companies to improve their ESG standards. This can also be shown to enhance returns. A 2017 research paper by three academics analyzed a dataset of 660 companies that had agreed to some form of engagement for a range of ESG issues, with 847 separate engagements in total.
The research found that the engaged companies saw stock returns that were 2.7% higher than non-targeted firms in the six months after the engagement ended. The results for companies which previously had had low ESG scores were even more marked, as their share prices outperformed non-targeted companies by 7.5% in one year after the end of the engagement.4
Changing business models
Taken together, a growing body of evidence concludes that companies which are progressively more sustainable today will reap the rewards in the future – and it may even save their businesses. Oil companies, for example, are slowly changing their business models to replace fossil fuels with renewables, while car makers are switching to electric vehicles, and retailers are sourcing only from suppliers with verified human rights records.
Should carbon limits ever be introduced, those companies that are cutting their carbon footprints now will be better placed to deal with new regulatory or governmental regimes in the future. This is already an issue for real estate companies, and for virtually all utilities. Meanwhile, the greater efficiencies enjoyed today will cut costs and raise profits.
Put simply, taking sustainability issues into account leads to better-informed investment decisions, and that leads to better returns in the long term. This is why Robeco remains convinced that it works, and has integrated ESG analysis in the investment process for fundamental and quantitative equities, and for fixed income.